Is A Flat Yield Curve A Harbinger Of Bad News?

Summary

• The spread between 2-year and 10-year Treasuries is razor thin.
• The yield curve has inverted just prior to the previous three recessions.
• Tens of millions of people outside the labor force and falling RV shipments also suggest the economy is headed for recession.
• There could be pain ahead for the economy, and stocks with high debt loads and cyclical business operations.
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On the surface the U.S. economy appears to be strong. The unemployment remains well below 5% (considered full employment). Average hourly wage growth for the month of October was over 3%, implying workers could switch jobs or demand higher wages from employers for staying put. However, the yield curve could be painting a much different picture. The spread between the 3-year and 5-year Treasury yields inverted earlier this week for the first time in over a decade:

For yield-curve watchers, the spread between 3- and 5-year Treasury yields inverted Monday, dropping to negative 0.6 basis points - its first time since 2007. To be sure, the 3/5 spread isn't the most widely watched measure. That's more likely to be the 2/10.

“The outright inversion could be reflective of the market pricing in some cuts starting in 2020, which may be helping the 5-year tenor outperform slightly,” said TD Securities rates strategist Gennadiy Goldberg.

Some suggested the inversion didn't necessarily foreshadow anything. After all, it is a minor part of the yield curve. The most watched is the spread between the 2-year and 10-year Treasuries. The 2-year yield is 2.83% and the 10-year is at 2.99% - a 15 basis point spread. It's also very flat, and dangerously close to becoming inverted.

Bond King Jeffrey Gundlach, CEO of Doubleline Capital, suggested the bond market signaled a weak economy:

Jeffrey Gundlach, chief executive officer of DoubleLine Capital, said the U.S. Treasury yield curve inversion on short-end maturities was signaling the "economy is poised to weaken."

Gundlach told Reuters the Treasury yield curve from two- to five-year maturities is suggesting "total bond market disbelief in the Federal Reserve's prior plans to raise rates through 2019."

The Fed is hiking short-term rates to beat back inflation as signaled by rising wage growth and growth and personal consumption expenditures ("PCE") at or above 2%. Asset prices such as real estate and stocks have been elevated for years, and I believe the Fed is attempting to burst these asset bubbles. The fact that investors are willing to bid up prices for bonds suggest they do expect rising prices in the future to eat into their fixed income stream. I believe them.

Significance Of An Inverted Yield Curve

The following chart shows 10-year Treasury yields minus 2-year Treasury yields historically. The shaded areas of the chart reflect when the U.S. economy went into recession. Prior to the last three recessions the yields on long-term bonds minus the yields on short-term bonds were negative, or "inverted."

Many economists missed the signs of the Financial Crisis of 2008. They now proactively search for clues to the next recession. An inverted yield curve's predictive powers are what make it such an important tool. If the Fed keeps raising short-term rates then the yield curve could go inverted. If that happens then politicians could change the tone on how strong the economy is and how a levitated stock market is a sign of economic strength.

Other Signs Suggest The Economy Is Not On Strong Footing

I have long held the belief that government stimulus after the Financial Crisis was tilted too much toward corporations and the wealthy. High income individuals have a lower marginal propensity to consume vis-a-vis middle income and lower income individuals. That implies the wealthy may spend less of their earnings or gains from the stimulus relative to others - that's not good for the economy.

Despite October's low unemployment rate, nearly 96 million people are outside the labor force, which could be considered a national crisis. The low unemployment rate could be partially driven by the fact that millions of working age people have given up looking for jobs. These individuals are not counted as part of the unemployment rate. It also could be a clear sign that government stimulus and e macroeconomic growth are not trickling down to the masses.

A decline in RV shipments also could be a harbinger of a recession. RV sales began falling in 1999 and the economy faltered two years later. From 2006 to 2007 RV shipments fell by over 9%, and the Financial Crisis occurred shortly thereafter. Through year-to-date October 2018 RV shipments were down 1% Y/Y. They are expected to fall about 5% for full-year 2018 and fall by mid single-digits in 2019. This is a sea change from white-hot sales over the past few years.

RVs can cost as much as $90,000 per unit. These discretionary items are often the first to get cut if consumers want to tighten the belt or do not feel optimistic about the future. That could lead to fewer jobs for RV manufacturers and salespeople and less sales of supplies into RVs. That decline in discretionary spending could metastasize to other parts of the economy. This also could spell bad news for RV-related names like Thor (THO) and LCI Industries (LCII).

Conclusion

A flat yield curve and falling RV shipments signal a recession could be on the horizon. I believe there's pain ahead for the economy and stocks with high debt loads and cyclical business operations.

Analyst’s Disclosure: I am/we are short THO, LCII. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.